Sylvia Ponders the Curious Case of the Supply-Side Tax Cuts
Feb. 10, 2001

The resemblance is striking, thought Sylvia. Twenty years ago, President Reagan cut taxes and increased military spending. Now, President Bush seeks to do the same.

But there the similarities end. In the early 1980s, the economy was in the throes of a recession. Unemployment, inflation, interest rates were all markedly high. Now, the economy is operating near full employment, inflation is quiescent, and interest rates are low. Moreover, the budget situation that seemed uncompromisingly bleak just a few years has improved dramatically. Over the next 10 years, projects the Congressional Budget Office, the accumulated surpluses will reach an astounding $5.6 trillion, enough to pay off the national debt and then some.

With the economy in seemingly fine fettle, thought Sylvia, why would the policies of the early 1980s find themselves back in fashion?

Well, the economic picture has turned grim in the last few months. The economy has slowed sharply, with output growing a mere 1.4% in the fourth quarter of 2000, and possibly, in the first quarter of this year, not growing at all. Although unemployment in December stood at a historically low 4.0%, a spate of layoffs, primarily in the manufacturing sector, caused the jobless rate to climb to 4.2% in January. With signs of a slowdown becoming increasingly evident, the Federal Reserve has decided that its usual nemesis, inflation, now merits less attention than the specter of a recession. Accordingly, it has altered its monetary policy, cutting interest rates twice this year already and poised to cut yet again.

But monetary policy is not the only weapon in the government's arsenal. To counter the sharp decline in consumer confidence, noted Sylvia, President Bush proposes to cut taxes. The logic is straightfoward: If marginal income tax rates are reduced, households will find that their disposable incomes have increased. This will encourage them to spend more on goods and services. Firms, noting the increase in aggregate demand, will respond by increasing output and hiring additional workers, thus staving off the dreaded recession.

This argument, now increasingly heard from conservatives clamoring for the tax cut, is curiously at odds with their supposedly supply-side stance. Look at the editorials in The Wall Street Journal, steeped in supply-side lore and ready to disparage policies seeking to boost aggregate spending. "Discredited Keynesian policies," they huff -- when will governments realize that demand-side management (championed by John Maynard Keynes) is doomed to failure?

Yet, noted Sylvia, demand-side Keynesian policies are precisely what are being touted as the elixir for the ailing American economy today. Cut taxes, the Republicans assert, and spending will go up. True enough, thought Sylvia, but whatever happened to their standard supply-side argument -- viz. that tax cuts will stimulate aggregate supply by boosting savings and investment?

Supply-side effects, noted Sylvia, take place with a noticeable lag. By the time the beneficial effects of the tax cut on savings and investment are felt, the economy may have long since emerged from a recession. With the economy facing an imminent downturn, what is really needed is an immediate boost to aggregate demand -- via Keynesian policies that conservatives have long derided.

But are President Bush's proposed tax cuts the right kind? Ah, thought Sylvia, therein lies the question.